What's Eating You How to cope with investing risk when everything seems uncertain
By Jason Zweig

(MONEY Magazine) – Just two years ago, when stocks were soaring, the concept of risk meant little to most investors. The greatest risk, it seemed, was that you might bump into somebody at a barbecue who was getting richer off dotcom stocks than you were. But suddenly risk seems to mean a whole lot more: You might lose a ton of money, your job, maybe even your life.

Fortunately, you can manage risk more effectively by understanding it better. Psychologists have gained two key insights that investors can capitalize on: People chronically mislead themselves about risk, overestimating how often bad events occur; and, when things do go wrong, we underestimate the likelihood that we'll recover. At first, this may not seem to have much to do with investing. But it does. Successful investing is all about managing your reactions to risk, so you can stay put for the long haul, while less steady investors panic and sell. In these unsettled times, thinking about risk is one of the smartest things an investor can do.

The illusion of control

Paul Slovic, a psychologist at the University of Oregon, has spent decades studying how we decide what's risky and what isn't. His most fascinating finding: How risky something actually is has almost nothing to do with how risky we think it is. Slovic has demonstrated that people think skiing is safer than flying on a commercial aircraft, that smoking is less dangerous than being around handguns, that nuclear power plants are riskier than cars. Try a couple of questions yourself: Do more Americans die of suicide or homicide? Which is more lethal, kidney disease or AIDS?

If you're anything like me, you'll get most of these riddles wrong. Last year, according to the U.S. Government, nearly twice as many people (28,000) killed themselves as were murdered, and kidney diseases caused nearly three times as many deaths as AIDS. Although Americans consistently rate nuclear power as one of the most dangerous of all technologies, it's actually safer by any objective measure than most other forms of power. And two of the deadliest things in America are cigarettes and cars; auto accidents alone kill an average of 115 Americans every day.

One oddity of human nature is that we underestimate risk when we think we're in control. We tend to feel a greater sense of invulnerability behind the wheel of our own car than as passengers on a plane. The feeling of being in charge seems to overwhelm our recollection that driving is statistically dangerous. You probably think suicide is rarer than homicide because it's easier to imagine someone else--outside your control--killing you than it is to imagine killing yourself. This illusion of control is one reason why day-traders felt so confident back in 1999: They thought they were in charge of how their stocks performed. In reality, the market was. Now that we've all seen that we can't control what our stocks do, investing seems riskier.

Slovic has shown that images of dreadful events like fires and explosions also confuse our perception of risk, leading us to think such disasters happen more often than they really do. Likewise, an unfamiliar risk--an outbreak of Ebola virus, say--will appear more likely to recur than objective evidence suggests. This explains why anthrax has become so scary and why it's suddenly so easy to imagine the stock market cascading unstoppably downward.

A sense of risk can infect you without your even being aware of it. Psychologists have found that merely reading about deaths caused by homicide or leukemia can lead people to overestimate the risk of hazards that have nothing at all to do with leukemia or homicide. Thus in the wake of Sept. 11, an intangible feeling of risk fills the air.

The uses of fear

To act rationally, you need to separate how risky a situation feels from how risky it really is. Scientists now believe that our brains make judgments in two basic ways: with an emotional, rapid-response system and an analytical, slower-moving side. To make consistently rational choices, we need both.

Led by Antonio Damasio at the University of Iowa, neurologists have shown that we rely on our emotions even when engaged in advanced reasoning. In one famous case, a railroad worker named Phineas Gage suffered a freak accident in 1848 that damaged the part of the brain that processes emotion. Scientists observed that Gage's intelligence and logical reasoning were unimpaired--but the injury crippled his ability to make long-term plans or major decisions. Without normal input from his emotions, rationality alone couldn't guide him to sound judgments.

In other words, we think both with our heads and our hearts. "Visceral emotions can cause us to do things that aren't wise," says Slovic. "But a faint whisper of emotion can help us fine-tune our analysis." The trick is to recognize that you're driven partly by your feelings and to integrate them into your analytical judgments. When danger seems acute, people rely more on emotion and less on analysis. In the days after the market reopened for trading on Sept. 17, for example, many investors panicked and dumped their stocks. As a result, they missed out on one of the best months in the Nasdaq's history, as the index surged 22% from Sept. 21 through Oct. 25. In times like these, it's crucial to counterweight your emotions with objective data.

I once asked Brian Posner, a gifted fund manager at Fidelity and Warburg Pincus, how he knew that a stock was likely to work out well when he bought it. "If it makes me feel like I want to throw up," he replied, "I can be pretty sure it's a great investment." Posner wasn't being facetious. The best investments are often those that make you queasy; after all, if a stock has suffered a sickening drop, it may finally be selling at a worthwhile discount. Like Posner, you should listen to both your gut and your head. Think of your own fear as a barometer of how nervous other investors may be feeling. And, if you're scared, that's all the more reason to study the evidence carefully.

The shock of recovery

We often think, when we're upset, that we'll stay that way. "People underestimate their ability to adapt to both good things and bad," says George Loewenstein, an economist at Carnegie Mellon. "Think of what happens when you drive past a terrible accident by the side of the road. You hit the brakes and say, 'That guy must have really been speeding,' and you promise yourself you'll never go too fast again. But an hour later, there you are, back to driving 79 mph."

In the heat of the moment, explains Loewenstein, we expect our current feelings to last for ages. But as time passes, we feel better--even after traumas like the death of loved ones. Daniel Gilbert, a behavioral scientist at Harvard, calls this mental quirk the "psychological immune system." Because we imagine that our reactions to bad events will never fade, we tend to feel especially good when we recover from trauma with unexpected speed. When fear and panic run hot, it seems inconceivable that anyone will ever calmly buy stocks again. But once those emotions recede, we're surprised at how much better we feel--one reason why bear markets often end suddenly, in stunning surges of bullishness.

Thus, as an investor, you should realize that the pundits who are proclaiming that "nothing will ever be the same again" are almost certainly wrong. We're likely to recover sooner than most of us imagine. Realizing this can help you stay put in the market, so you won't be left behind as it rebounds.

Of course, long-term investing returns have almost nothing to do with how you, or anyone else, feels right now. In the end, stocks are driven by earnings, not emotions; bond returns are based on interest rates, not intuition. But that's hard to remember when everyone is so full of anxiety.

The best way to prevent your emotions from bulldozing your judgment is by forcing your logical side to weigh in. Psychologist Paul Slovic suggests asking yourself, "What really is worrying me? What evidence do I have about how likely it is? Has the world changed so drastically that the past has no relevance to today?" (A quick check at, say, www.djindexes.com will show you that there is no historical evidence that war or physical disaster is bad for the U.S. stock market.)

Finally, remember George Loewenstein's observation: "People underestimate their own powers of recuperation from emotional trauma." None of us will ever forget the horror of Sept. 11, but someday we'll look back and be amazed at how much calmer we've become. In the end, we'll find that investing victory will belong to those who realized, early on, that psychological victory was possible.

Jason Zweig can be reached at fundamentalist@moneymail.com.